Doyne Farmer interview: macroecnomics from bottom up
Agent-based modeling of housing market and macroeconomy, explained by Doyne Farmer:
The Fed’s latest thinking
Interview of Chicago Fed’s president Charles Evans, one of the vocal doves on the Fed’s Open Market Committee (or FOMC). Evans advocates the Fed should target on employment growth, and consider raising inflation target to 3%, instead of 2%.
He favors the Fed clearly states its future course of actions and offers clear forward guidance contingent on economic outlook. He cited a piece by Mike Woodford on FT, who made the following forceful argument:
…Mr Bernanke can and should use his speech today to explain how his policy intentions are conditional upon future developments.
A clarification could help the economy in two ways. First, he could signal that a temporary increase in inflation will be allowed, before policy tightening is warranted. This would stimulate spending by lowering real interest rates. Second, specifying the size of any permanent price-level increase would avoid an increase in uncertainty about the long-run price level. This in turn would ward off an increase in inflation risk premiums that might otherwise counteract the desirable effect of the increase in near-term inflation expectations.
Uncertainty about the economic outlook is likely now the most important obstacle to a more robust recovery. The problem is not just uncertainty about Fed policy, but the fact that the Fed has become harder to “read” does not help. Better Fed communication, long on the agenda, would be particularly helpful at this juncture. Jackson Hole provides Mr Bernanke with the ideal opportunity.
My problem with Woodford’s recommendation is, how can the Fed convince people that the raise of inflation target is going to be temporary? What if employment situation won’t get any better after raising inflation target to 3%? Will 4% then be tolerable? Will this generate a positive spiral of inflation (expectations)??
zombie American consumers
Stephen Roach points out one number that is enough to explain why this recovery has been so anemic:
The number is 0.2%. It is the average annualized growth of US consumer spending over the past 14 quarters – calculated in inflation-adjusted terms from the first quarter of 2008 to the second quarter of 2011. Never before in the post-World War II era have American consumers been so weak for so long. This one number encapsulates much of what is wrong today in the US – and in the global economy.
There are two distinct phases to this period of unprecedented US consumer weakness. From the first quarter of 2008 through the second period of 2009, consumer demand fell for six consecutive quarters at a 2.2% annual rate. Not surprisingly, the contraction was most acute during the depths of the Great Crisis, when consumption plunged at a 4.5% rate in the third and fourth quarters of 2008.
As the US economy bottomed out in mid-2009, consumers entered a second phase – a very subdued recovery. Annualized real consumption growth over the subsequent eight-quarter period from the third quarter of 2009 through the second quarter of 2011 averaged 2.1%. That is the most anemic consumer recovery on record – fully 1.5 percentage points slower than the 12-year pre-crisis trend of 3.6% that prevailed between 1996 and 2007.
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I have been tracking these so-called benchmark revisions for about 40 years. This is, by far, one of the most significant I have ever seen. We all knew it was tough for the American consumer – but this revision portrays the crisis-induced cutbacks and subsequent anemic recovery in a much dimmer light.
The reasons behind this are not hard to fathom. By exploiting a record credit bubble to borrow against an unprecedented property bubble, American consumers spent well beyond their means for many years. When both bubbles burst, over-extended US households had no choice but to cut back and rebuild their damaged balance sheets by paying down outsize debt burdens and rebuilding depleted savings.
Yet, on both counts, balance-sheet repair has only just begun. While household-sector debt was pruned to 115% of disposable personal income in early 2011 from the peak of 130% hit in 2007, it remains well in excess of the 75% average of the 1970-2000 period. And, while the personal saving rate rose to 5% of disposable income in the first half of 2011 from the rock-bottom 1.2% low hit in mid-2005, this is far short of the nearly 8% norm that prevailed during the last 30 years of the twentieth century.
Toss out the old valuation metrics
These days it's hard to take your eyes off the volatile markets. One metric that investment gurus use to argue whether the market is overvalued or undervalued is the P/E ratio. There is a group of people who prefer to use Bob Shiller's 10-year PE to smooth out the noises of business cycles. But none of these took into consideration of the demographic change the US is facing in coming decades when "baby boomers", born between 1946-1964, reach their retirement age, i.e., between 2011-2029.
Should we expect the same valuation as in previous decades? The recent research from San Francisco Fed. offers us some insights:
To examine the historical relationship between demographic trends and stock prices, we consider a statistical model in which the equity price/earnings (P/E) ratio depends on a measure of age distribution (for another example, see Geanakoplos et al. 2004). We construct the P/E ratio based on the year-end level of the Standard & Poor’s 500 Index adjusted for inflation and average inflation-adjusted earnings over the past 12 months. We measure age distribution using the ratio of the middle-age cohort, age 40–49, to the old-age cohort, age 60–69. We call this the M/O ratio.
Figure 1 displays the P/E and M/O ratios from 1954 to 2010. The two series appear to be highly correlated.
Figure 2 compares the actual and model-implied P/E ratios for the sample period ending in 2010. We calculate the path for the model-implied P/E during the sample period by feeding in actual M/O ratios. We call the long-run path of the P/E ratio predicted by the model the “potential P/E ratio” and designate it P/E*. Figure 2 shows that the P/E* (red dashed line) is highly correlated with actual P/E during the sample period.
Jeremy Siegel on market opportunities
Jeremy Siegel, professor at UPenn and founder of WisdomTree, also a long-term bull on equity, offers his insight on the investment opportunities after the heavy selloff of last few weeks.
He had a short: TIPS;
He had a long: dividend-paying stocks, excl. financials.
Are we repeating the same mistakes as Japan?
Debt-deleveraging and its economic consequences.
The perspective from Japan – interview of Richard Koo of Nomura.
David Rosenberg shares his latest assessment of data points. He called another recession “virtual certainty”.